The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must

KnowGlenn R. CasterlineManaging Director

Discussion Outline

Why Should Treasurers Care?

Fundamentals of the Arbitrage Rebate and Yield Restriction Requirements

Amounts Subject to the Requirements

Arbitrage Rebate Payments vs Yield Reduction Payments

Investing Bond Proceeds

Exceptions to the Arbitrage Rebate Requirements

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Why Should a Treasurer Care?

Finance Director’s responsibility (really?)

Arbitrage Bonds = Taxable Bonds

Fixed earnings target

Making a payment is a good thing

Basic understanding of the arbitrage rebate & yield restriction requirements will influence your investment strategies

Bond proceeds are often the “forgotten” assets

• Arbitrage Bonds = Taxable Bond

• Making a rebate or yield reduction payment is a good thing

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Fundamentals - General

2 separate requirements though related

Need to comply with both requirements to avoid bonds being declared “Arbitrage Bonds”• The arbitrage

rebate and yield restriction requirements are related but are also two separate requirements

• Need to comply with both requirements

Arbitrage Rebate

Yield Restriction

Arbitrage rebate – issuers can achieve compliance by remitting a rebate payment to the IRS

Yield restriction – issuers can achieve compliance by…… Investing yield restricted amounts at a yield below the

bond yield or.. Remitting a yield reduction payment to the IRS

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Fundamentals – Arbitrage Defined

Borrow at tax-exempt rates and invest at higher taxable rates without incurring any additional risk

Positive and negative arbitrage

When the yield curve is upwards sloping tax-exemption of bond interest allows for positive arbitrage

• Positive arbitrage can be offset by negative arbitrage

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What Is Arbitrage?

Investment Yield Bond Yield

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Fundamentals – Legislative History

Tax-exemption is a federal subsidy

System was abused

Laws and regulations were established to discourage issuers from:

Issuing more bonds than needed

Issuing bonds sooner than needed

Leaving bonds outstanding longer than needed

• Tax exemption is a Federal subsidy

• Regulations discourage Issuers from:

• Issuing more bonds than needed

• Issuing bonds sooner than needed

• Leaving bonds outstanding longer than needed

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Amounts Subject to the Requirements

• Most amounts with a nexus to the bond issues are subject to the rebate requirements

• Some amounts are subject to the yield restriction requirements

Arbitrage Rebate

Gross proceeds• Sale proceeds –

amounts received from the sale of the bonds

• Investment proceeds – earnings on sale proceeds

• Replacement proceeds – typically amounts pledged to pay debt service

• Transferred proceeds – prior bond proceeds that become proceeds of the refunding bonds

Yield Restriction

Amounts remaining beyond applicable “temporary period” (3 years)

Amounts beyond the “reasonably required reserve”, Maximum of . .

• 10% of par amount

• 125% of average annual debt service

• Maximum annual debt service

Advance refunding escrows

Transferred proceeds

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Amounts Subject to the Requirements

Most amounts with a nexus to the bond issues are subject to the rebate requirements

Some amounts are subject to the yield restriction requirements

Arbitrage Rebate

Fund/Account Yield Restriction

Yes Construction Fund Amounts remaining after “temporary period”

(3 years)

Yes Capitalized Interest Account

Amounts remaining after “temporary period”

(3 years)

Yes Reserve Fund Only amounts above “reasonably required

reserve”

Yes Escrow Fund Beginning on the issue date

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Arbitrage Rebate Payments vs Yield Reduction Payments

An arbitrage rebate or yield restriction liability compares….

Actual earnings What you would have earned had you invested the same

proceeds at the bond yield

Arbitrage rebate and yield reduction payments consist of the net amount of positive arbitrage required to be remitted to the Federal government

An arbitrage rebate payment is net of any yield reduction payments (You are not paying twice)

• Liability = actual earnings vs earnings at the bond yield

• Rebate payments are offset by yield reduction payments

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Arbitrage Rebate Payments vs Yield Reduction Payments

• Liability = actual earnings vs earnings at the bond yield

• Rebate payments are offset by yield reduction payments

Summary of Arbitrage Rebate Analysis

Fund Computation InternalReference Fund Current Date Gross Rate of ExcessNumber Description Fund Status Valuation Earnings Return Earnings

1 Reserve Fund Active $4,222,050.03 $868,347.10 4.167482% ($85,639.16)2 Acquisition Fund (#282) Active $1,220,413.77 $3,291,460.12 5.683172% $778,253.673 Proceeds Transfer Fund Inactive $0.00 $5,141.38 5.005770% $594.60

Totals: $5,442,463.80 $4,164,948.60 $693,209.11

Summary - RebateArbitrage Yield: 4.537966%Return on Investments: 5.300656%Excess %: 0.762690%Actual Gross Earnings: 4,164,948.60Allowable Gross Earnings: 3,496,800.63Excess Earnings: 693,209.11FV of Computation Date Credit (December 9, 1998): (1,196.61)FV of Computation Date Credit (December 9, 1999): (1,144.10)FV of Computation Date Credit (December 9, 2000): (1,093.90)FV of Computation Date Credit (December 9, 2001): (1,045.89)FV of Computation Date Credit (December 9, 2002): (1,000.00)Less: Yield Restriction Liability: (19,580.64)Cumulative Rebate Liability: $668,147.97Rebate Payment Due: $601,333.17

Summary of Yield Restriction AnalysisYield

Fund Computation Internal RestrictedReference Fund Current Date Gross Rate of ExcessNumber Description Fund Status Valuation Earnings Return Earnings

2 Acquisition Fund (#282) Active $1,220,413.77 $154,494.92 5.309376% $19,580.64

Totals: $1,220,413.77 $154,494.92 $19,580.64

Summary - Yield Restriction 1

Arbitrage Yield: 2 4.662966%Return on Yield Restricted Investments: 5.309376%Excess %: 0.762690%Actual Gross Earnings: 154,494.92Allowable Gross Earnings: 134,914.28Yield Restriction Liability: $19,580.64Yield Reduction Payment Due: $17,622.58

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Arbitrage Rebate Payments vs Yield Reduction Payments

• Liability = actual earnings vs earnings at the bond yield

• Rebate payments are offset by yield reduction payments

Total Earnings - Acquisition Fund

$3,291,460.12$3,271,879.48

$2,513,206.45

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Retainable Earnings - Yield Restriction

Total Earnings

Retainable Earnings - Arbitrage Rebate

Yield Restriction Liability = $19,580.64

Arbitrage Rebate Liability = $778,253.67

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Arbitrage Rebate Payments vs Yield Reduction Payments

• Liability = actual earnings vs earnings at the bond yield

• Rebate payments are offset by yield reduction payments

Arbitrage Rebate & Yield Reduction Payments

0

100,000

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Acquisition Fund

IRS

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ents Yield Reduction Payment

Rebate Payment

Arbitrage Rebate Liability = $778,253.67

Arbitrage Rebate Payment = $758,673.03

Yield Reduction Payment = $19,580.64

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Arbitrage Rebate Payments vs Yield Reduction Payments

Arbitrage rebate and yield reduction payments are required to be paid no later than 60 days after each “5th Bond Year” and 60 days after the final redemption date

“My bonds have been refunded, so they are no longer subject to the arbitrage rebate and yield restriction requirements”.

Defeased vs Redeemed

• Payments are due 60 days after every “5th Bond Year” and after the final redemption date of the Bonds

• Bonds are subject to the arbitrage rebate and yield restriction requirements until the Bonds are redeemed in full

Description Original Bonds Refunding Bonds

Issue Date January 15, 1996 June 1, 2005

Debt Service Payment Dates April & October April & October

First Optional Redemption Date October 1, 2006 October 1, 2015

Defeasance Date June 1, 2005

Redemption Date

October 1, 2006

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Investing Bond Proceeds - Fundamentals Fundamental investment objectives include…..

SafetyMinimize credit risk to investment principal

LiquidityAssure appropriate liquidity for required

withdrawals

•Minimize market risk

•Minimize reinvestment rate risk

Duration of investments, accessibility to funds

Yield

Generate consistent risk-adjusted returns

• Investment fundamentals

•Safety

•Liquidity

•Yield

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Investing Bond Proceeds - Objectives Avoid or limit opportunity costs

Interest costs accrue on bonds immediately

Negative carry increases financing costsImproved investments lower overall bowering

costs Net-funded project funds

More earnings=less debt issued Reserve Funds

More earnings=less net debt service

• Avoid or limit opportunity costs

• Higher earnings = less debt issued

• Higher earnings on the reserve = less net debt service

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Investing Bond Proceeds - Objectives

Investing bond proceeds requires an unique investment philosophy

Unlike most entities, tax-exempt issuers can develop a “perfect” investment strategy

Plan for any rebate or yield reduction payments

Positive arbitrage is a good thing, as long as it is not a surprise

Example: surety bond vs cash funded reserve

• Avoid or limit opportunity costs

• Avoid surprises. Plan for rebate or yield reduction payments

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Investing Bond Proceeds - Objectives

• Avoid or limit opportunity costs

• Avoid surprises. Plan for rebate or yield reduction payments Surety Bond Reserve Fund

Amount Borrowed $150,000 $5,000,000

Investment Rate NA 4.90%

$50,000,000 new money financing 25 year amortization Bond yield = 4.54% Construction Fund = 4.19%

Total debt capacity may play a key role in determining whether to purchase a surety bond or fund a Reserve Fund

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Exceptions to the Arbitrage Rebate Requirements

All or a portion of the bond proceeds may be excluded from the arbitrage rebate requirements if they meet a spending exception

If you earned positive arbitrage and met an exception you allowed to keep the earnings

Spending exceptions

6 month spending exception Gross proceeds need to be spent within 6 months Gross proceeds do not include amounts deposited

in the Reserve Fund

• All or a portion of the bond proceeds may be excluded from the rebate requirements if they meet a spending exception

• Positive arbitrage can be retained if a spending exception is satisfied

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Exceptions to the Arbitrage Rebate Requirements

Spending exceptions (continued)

18 month spending exception Spending requirements

•15% in 6 months

•60% in 12 months

•100% in 18 months Gross proceeds do not include amounts deposited

in the Reserve Fund

• All or a portion of the bond proceeds may be excluded from the rebate requirements if they meet a spending exception

• Positive arbitrage can be retained if a spending exception is satisfied

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

Exceptions to the Arbitrage Rebate Requirements

Spending exceptions (continued)

24 month spending exception Applies to “construction” bonds only Only includes “available construction proceeds”

•Construction Fund

•Capitalized Interest Account

•Reserve Fund earnings Spending requirements

•10% in 6 months

•45% in 12 months

•75% in 18 months

•100% in 24 months

• All or a portion of the bond proceeds may be excluded from the rebate requirements if they meet a spending exception

• Positive arbitrage can be retained if a spending exception is satisfied

The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know